Nobels Give Econometrics Pioneers Their Due: Lars Peter Hansen

Oct. 13 (Bloomberg) -- Thomas J. Sargent and Christopher A.
Sims richly deserve the Nobel Memorial Prize in Economic
Sciences they were awarded this week for their seminal work in
the fields of macroeconomics and time series econometrics.

I was fortunate to have a front-row seat to observe the
development of their path-breaking research. As a graduate
student at the University of Minnesota in the 1970s, I was a
research assistant for both: Sims became my adviser, and Sargent
was a member of my dissertation committee. Since then, Sims, who
now teaches at Princeton University, has had a major influence
on my research, and Sargent, at New York University, has been my
longtime collaborator.

Starting in the 1970s, Sargent and Sims began to publish
their remarkable contributions, which combined macroeconomic
models with time series analysis in a unique way to address
policy questions in macroeconomics. These insights were only
possible with rigorous economic modeling and careful empirical
analysis.

Time series analysis, applied to macroeconomics, provides
the tools to examine some important questions that can’t be
answered on purely statistical grounds without some form of
economic modeling. How do we use macroeconomic time series data
to identify and measure meaningful shocks or impulses to the
economy, such as shifts in technology or monetary policy? How do
we assess the accuracy of the resulting measurements? How do we
use historical data to make inferences about the impact of
alternative macroeconomic policies, including ones that are
outside the range of historical experience?

Time Series

To provide answers, Sargent and Sims devised and applied
methods that used time series statistical methods concurrently
with dynamic economic models. Their approaches were distinct but
complementary.

Sims illuminated what was required to use multivariate time
series data to make causal statements. He also developed and
applied methods that measure the effect of alternative sources
of fluctuations and the uncertainty associated with those
measurements.

This work by Sims and other researchers who used his
methods challenged the monetarist view of macroeconomic policy
and its impact on economic outcomes.

Initially, Sims investigated the time series relationship
between money and aggregate output. Roughly speaking, his
results were consistent with a view commonly held by monetarists
of how the aggregate economy responds to exogenous movements in
the money supply.

Multiple Variables

Yet when he made the model more complex by incorporating
additional economic time series such as interest rates, the
interpretation changed entirely. That finding upended previous
analysis that focused on a single relationship with a monetary
aggregate as the explanatory time series.

Instead, Sims showed why it was essential to study a richer
collection of time series simultaneously, allowing for flexible
and convenient interrelated feedback.

Using a statistical model called vector autoregressions,
Sims and others proposed ways to extract meaningful shocks using
“identifying restrictions” from economic analysis. This gave
researchers the ability to measure the impacts of such shocks,
including monetary ones, over multiple periods on macroeconomic
time series.

As Sims put it: “With a variety of identifying
assumptions, a consistent picture has emerged: Monetary
contraction produces a decline in output and a decline in
inflation, with both responses smooth and delayed and the
decline in output quicker.”

Inflation Model

These insights have been extended to provide a more
complete picture of changes in monetary regimes during the
postwar period. His empirical analyses and those of others serve
as a basis for economic models that show the interaction of
fiscal and monetary policy as an essential determinant of prices
and inflation.

This is merely one example. Sims’ impact on applied
research in macroeconomic time series is pervasive, and his work
is widely used in policy research by governmental agencies.

Sargent is an innovator in developing and using state-of-the-art dynamic economic models to deduce the implied
restrictions on the economic time series.

His approach allows researchers to examine or test model
implications using data on economic time series. His empirical
analyses explored a wide variety of macroeconomic questions,
including unemployment and inflation.

Historical Research

He also has conducted important research that explores a
variety of current and historical evidence through the lens of
alternative economic models, always with the purpose of
understanding the ramifications for economic policy.

With other eminent scholars such as Robert Lucas, Finn
Kydland, Edward Prescott and Neil Wallace, he initiated research
demonstrating the need to alter macroeconomic policy when
economic actors are forward-looking and rational. Based on this
research, issues about credibility and commitment on the part of
policy makers became central to the analysis of policy.

Sargent also explored the implications of these ideas in
empirical investigations, for example, in his studies of
European hyperinflations and fiscal policies used historically
by European countries to finance wars.

A great example of this historical work is his study with
Francois Velde of government debt, defaults and the subsequent
inflation around the time of the French Revolution. Although the
British had an established reputation for managing government
debt, France did not. As a consequence, the macroeconomic
outcomes for the two countries were substantially different.
Their study explains why French policies led to fiscal
imbalances, defaults and inflation along with government
instability.

Rational Expectations

Sargent has continually found new tools for interpreting
economic time series. Although he initially featured models in
which individuals formed rational expectations, he subsequently
focused on models with learning dynamics that can occur when it
is hard for policy makers to distinguish among competing models.

In his 2001 book, “The Conquest of American Inflation,”
Sargent shows how policy makers maintain confidence in one model
for sustained periods of time, but sometimes shift views quickly
after they examine historical data. This abrupt shift can induce
inflationary episodes, and the “conquest” isn’t permanent.

Like Sims, Sargent challenged so-called monetarist views by
showing why considerations of fiscal policy and its interactions
with monetary policy are crucial to understanding the
determination of prices and inflation. With this and many other
insights and contributions, Sargent and Sims transformed the
theory and practice of economics.

(Lars Peter Hansen, the David Rockefeller distinguished
service professor at the University of Chicago, is a contributor
to Business Class. The opinions expressed are his own.)